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Fannie, Freddie Deflected Risk Warnings
For Years, Critics Sounded Alarms About Firms' Thin Capital Reserves

By David S. Hilzenrath
Washington Post Staff Writer
Monday, July 14, 2008

Though the implosion of investor confidence in Fannie Mae and Freddie Mac last week was sudden, the worries driving it have been the subject of countless warnings over many years.

From a Washington think tank to the halls of Congress, from the Treasury to the Federal Reserve, from the Clinton to the Bush administrations, critics of the government-sponsored mortgage giants have long argued that they were allowed to operate with financial cushions that were too thin to support their far-reaching financial risks.

The critics argued that regulators should be empowered to require deeper capital cushions at Fannie Mae and Freddie Mac, but their persistent efforts were thwarted in the face of the companies' formidable lobbying. Many members of Congress defended the companies, contending that efforts to rein them in were tantamount to an assault on housing.

The critics' warnings finally hit home for investors last week in a frenzy of panicked selling. The companies' stocks sank to dizzying lows as fear spread that the twin titans of the mortgage market had overextended themselves, potentially requiring a government rescue.

Whether Fannie Mae, of the District, and Freddie Mac, of McLean, could ride out the housing crisis on their own remained to be seen. They said their finances were sound, and their chief regulator was trying to allay the fears. But any sense that their shares were the safest of investments had clearly been shattered.

The government created the firms to keep money flowing to mortgage lenders. They do that by buying mortgages and pooling them into securities for sale to other investors, guaranteeing to pay the investors if the borrowers default.

Their unusual status was the key to their business. The fact that they are federally sponsored led the financial markets to believe the government would cover their debts if they were unable to do so themselves. The assumption that they were virtually as reliable as the U.S. Treasury enabled them to borrow at low rates and fund their investments with cheap money. It also helped them charge a premium for their mortgage guarantees.

As Alan Greenspan described in 2004, the result was rapid growth, high concentrations of risk and insulation from the discipline the market applied to ordinary companies.

"Unlike many well-capitalized savings and loans and commercial banks, Fannie and Freddie have chosen not to manage that risk by holding greater capital," Greenspan, then chairman of the Federal Reserve, told lawmakers in 2004. To keep them from undermining the financial system, "preventive actions are required sooner rather than later," he added.

As of March, when the government provided its most recent snapshot, the companies had $81 billion of capital to absorb potential losses -- a big number, but only a fraction of their $5.1 trillion of investments and loan guarantees.

Fannie Mae argued that housing was such a safe investment that it didn't need as much capital as banks, which make a wide variety of loans. But having all their eggs in one basket left Fannie Mae and Freddie Mac all the more vulnerable to a downturn in the housing sector. As home prices have plunged and defaults and foreclosures have soared, the companies have lost billions of dollars and face the prospect of losing billions more.

The political battle lines were drawn by 2000, when a senior Clinton administration official called on Congress to take steps that might have diminished the companies' special status. Treasury Undersecretary Gary Gensler also urged that regulators be given more power to set capital requirements for Fannie Mae and Freddie Mac.

The companies fought back.

"We think that the statements evidence a contempt for the nation's housing and mortgage markets," Freddie Mac spokeswoman Sharon J. McHale said at the time.

Even after Freddie Mac was shown to have manipulated earnings, Congress remained deadlocked over legislation to create a stronger regulator. Opposing one such bill in 2004, Sen. Charles E. Schumer (D-N.Y.) argued that a hostile regulator could use the proposed powers to choke the companies.

When a federal regulator accused Fannie Mae of cooking its books to increase bonuses, lawmakers lined up to denounce the regulator. Rep. William L. Clay Jr. (D-Mo.) said a House panel had no business holding a hearing on the matter -- "unless this is truly a witch hunt." Fannie Mae was later found to have overstated profits by $6.3 billion.

Former representative Richard H. Baker (R-La.), who chaired a subcommittee that oversaw the companies, struggled for years to rein them in and tried to show they were being managed for the enrichment of their executives. When Baker obtained data on Fannie Mae pay, a lawyer for the company threatened him with personal liability if he made it public, Baker recounted last week.

Critics of the two firms included former Reagan administration official Peter Wallison, who crusaded against them at the American Enterprise Institute, and a coalition of financial companies whose interests often conflicted with those of Fannie Mae and Freddie Mac. The Bush administration pushed a similar agenda.

"The simple truth is that there is no need for our financial markets to be exposed to this risk," Emil W. Henry, Jr., an assistant Treasury secretary, said in 2006.

On the other side, a top lobbyist for Freddie Mac held more than 75 fundraisers for members of the House Financial Services Committee in an 18-month period several years ago, raising nearly $3 million, according to records brought to light in a federal investigation. The lobbyist's fundraising dinners typically featured the committee's Republican chairman at the time, Michael G. Oxley of Ohio.

Those and other activities led to a record $3.8 million fine against Freddie Mac in 2006 for allegedly violating federal election law.

In an internal memo in 2004, Fannie Mae executive Daniel H. Mudd affirmed what the company's critics had long contended: In the political arena, "we always won" and "we took no prisoners."

"We used to, by virtue of our peculiarity, be able to write, or have written, rules that worked for us," wrote Mudd, now the company's chief executive.

As the housing market boomed in recent years, Fannie and Freddie, like many lenders, took on riskier loans. Freddie Mac executives have said they loosened lending standards to avoid losing market share.

Since the boom turned to bust, the government in some ways has given the companies freedom to dig themselves into a bigger hole. As other sources of funding for mortgages have dried up, the government has become more dependent than ever on Fannie Mae and Freddie Mac to keep the market functioning, and it has reduced their capital requirements.

Citing accounting and other issues, some analysts said the government has allowed Fannie Mae and Freddie Mac to paper over the extent of their problems, contributing to the market's loss of faith in them last week.

Freddie Mac spokeswoman McHale denied that allegation, a Fannie Mae spokesman declined to address it, and a spokeswoman for the Office of Federal Housing Enterprise Oversight, the companies' main regulator, did not respond to a request for comment.

"While Administration officials continue to claim the companies are adequately capitalized, the markets do not believe this," analyst Joshua Rosner of Graham Fisher & Co. wrote in a Friday report.

Ironically, the sell-off last week came as Congress was finally moving toward passing a bill containing the sort of preventive measures the critics sought -- among them, greater regulatory control over the companies' capital.

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